In the U.S., investors often leverage tax planning strategies to reduce their tax liabilities. Two of the most strategic methods for maximizing tax benefits are depreciation and cost segregation.
Depreciation (Wear and Tear)
Depreciation allows property owners to recover the cost of an asset over its useful life through tax deductions. This is accomplished by deducting a portion of the cost of the property each year from taxable income. The total amount that can be deducted depends on several factors, including the type of property and its classification.
- Standard Depreciation Periods:
- Residential Rental Property: Depreciated over 27.5 years.
- Commercial Property: Depreciated over 39 years.
Cost Segregation
Cost segregation is a tax planning tool that accelerates the depreciation of real estate investments. It involves identifying and separating personal property components from structural components of a building, allowing for a faster depreciation schedule on certain assets.
- Benefits of Cost Segregation:
- Accelerated Depreciation: By classifying building components into shorter-life categories (5, 7, or 15 years), investors can depreciate these components more quickly.
- Tax Savings: This strategy reduces current tax liabilities by increasing depreciation deductions, freeing up cash for reinvestment.
Bonus Depreciation
Bonus depreciation is an additional tax incentive that allows businesses to deduct a significant portion of the cost of qualified property in the year the property is placed in service.
- Key Points:
- Initial Bonus Depreciation Rate: Up to 100% for property placed in service after September 27, 2017, and before January 1, 2023.
- Declining Bonus Depreciation Rate:
- 80% for property placed in service in 2023.
- 60% for property placed in service in 2024.
- 40% for property placed in service in 2025.
- 20% for property placed in service in 2026 (unless Congress extends or alters the provision).
Qualified Assets for Depreciation:
Assets that can benefit from accelerated depreciation under cost segregation include:
- Flooring: Asphalt and tile.
- Lighting Fixtures: Fixtures and fittings.
- Data and Communication Outlets: Networking and cabling.
- Cabinets and Counters: Kitchen and bathroom fixtures.
Implications for Property Purchased or Renovated:
- New Purchases: Properties purchased and put into service after September 27, 2017, can qualify for 100% bonus depreciation, which will gradually reduce in the coming years.
- Existing Properties: Properties that are purchased or renovated can also be segregated and depreciated based on their components, potentially capturing additional depreciation from previous years.
Impact of the Tax Cuts and Jobs Act (TCJA) of 2017:
The TCJA introduced significant changes to depreciation rules:
- Increased Bonus Depreciation: Initially set at 100% for new and used qualified property.
- Extended Applicability: Bonus depreciation now applies to both new construction and used property acquired after September 27, 2017.
“Placed in Service” Definition:
A property is considered “placed in service” when it is ready and available for its intended use. For real estate, this is typically marked by the issuance of a Certificate of Occupancy.
Tax Planning Considerations:
- Carryforward of Losses: Losses from accelerated depreciation or other deductions can be carried forward indefinitely to offset future income, including capital gains.
- Strategic Planning: Leveraging these tax benefits requires careful planning to ensure compliance and maximize the benefits effectively.
Incorporating these tax strategies can substantially impact your investment returns and overall financial strategy. Consult with a tax professional to explore how these benefits can be tailored to your specific investment goals.
